Is the Gold Rally Getting Frothy?

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

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At the end of Globex trading in New York, spot gold was $1197.00 on Monday, December 1st. Gold then hit another record high during the evening in Hong Kong, with spot reaching $1217.23 an ounce. New highs were also reached in British pounds - 733.02, euros - 805.71, and in Swiss Francs - 1214.44. While U.S. investors are getting more bang for their buck, the gold rally is global and an indication of a broad-based lack of confidence in fiat currencies. This is a long-term trend and will be lasting well into the next decade, if not beyond. That doesn't mean gold will be going straight up however, there will be sharp reversals and investors need to watch out for them.

A major impetus for the current rally was Barrick Gold eliminating its fixed-price hedge book. Barrick wasn't making money on the continual rise in gold prices because of its hedging activities. Shareholders forced management to close them out. Barrick had to buy back the hedge contracts and this was originally expected to take somewhat into 2010 before this was finished. Apparently, Barrick closed out all the hedges by the end of November. This will cost Barrick $6.0 billion in charges against earnings. Gold has been rallying since 2001 and one wonders why it took Barrick management 8 years to react to this. Investors who think management and industry 'experts' always know their market best, might want to reconsider this notion. These are the people who frequently are the last to catch on to what is going on.

The end of an event that has been propelling a market should be paid attention to by investors. It can mark a temporary pause in an uptrend. Gold is already overbought on the daily and weekly charts, so it is vulnerable to some selling. The momentum however is extremely powerful and the current overbought state can last for awhile longer before selling comes in. The selling will only be temporary however. The peak of this rally is still at least a few months off.

Barrick gold closing out its hedges is only one of many factors pushing up the gold market. The declining U.S. dollar is a far more important. The trade-weighted dollar has been as low as 74.23 and has a band of support in the 72 to 74 level. A test of the March 2008 lows (the same month when gold first broke $1000 an ounce) below that band is almost certain. The euro testing the 1.60 level should be taking place around the same time. Lower lows for the dollar and a higher high for the euro should not be ruled out next spring. The longer term trends are pointing in that direction - and those are the trends that should be watched most closely.

Disclosure: Long gold.

NEXT: Our Current Economic Illusions

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21


This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Falling Supply and Rising Demand Cause Gold to Soar

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Our Video Related to this Blog:

February gold futures broke $1200 for the first time a little after 4AM New York time. February 2010 is now the major front month contract after the expiration of the December contract on November 30th. Gold futures were up 14% in November, the best monthly performance in ten years. Silver was also up 14%. Gold traded down only three days in November and hit one all-time high after another during that time. While the major U.S. stock indices were also up, gold and silver shined in comparison. Seasonally-weak oil was flat during the month. The trade-weighted U.S. dollar opened November above 76 and closed out below 75, hitting a new yearly low of 74.23 in the interim.

The price rise in gold is caused by a positive supply demand picture both for the physical metal and in the futures trading pits. For the last twenty years there have been three major sources of gold supply and three major destinations of gold demand. The sources for supply have been mining, scrap (also known as recycled gold) and central bank selling. The three majors uses for gold have been for jewelery, investment and industrial (contrary to popular belief, gold has a wide variety of uses in manufacturing, especially in electronics). Complicating the picture has been central bank leasing to miners, big banks and hedge funds that dumped significant amounts of gold on the market in the 1980s and 1990s and was a major factor in holding gold prices down. The unwinding of these positions, Barrick Gold closing out it hedge book is the most recent example, has been creating upward pressure on gold prices for several years now.

There are two major currents in the shift in market supply and demand. Central banks have shifted from the supply side to the demand side and ETFs have caused a major increase in investment demand. Up to mid-decade, central bank selling accounted for 14% of gold market supply, but in the first half of 2009, central banks became net buyers of gold. As supply dried up from central banks a new increase in demand was created by ETFs that buy and store physical gold. There are now eleven of these globally and none existed before 2003. Their gold holdings have gone from zero to 1766.40 tonnes in the last six years. The largest ETF, GLD, is now the sixth biggest holder of gold in the world (between France and China).

Gold mining has provided as little as 60% of market supply in recent decades. So far gold mining output peaked in 2001. It then fell seven years in a row until 2008. The only major producers with increasing output have been China and Russia. This may have more to do with their transitions from a communist to a more capitalistic economic model than with the contents of their gold mines however. South Africa, which was the top gold producer for much of the last 100 years, is experiencing a rapid drop in gold output and it looks like it will fall to fourth place in global rankings this year. It takes approximately ten years to open a new gold mine and gold prices only started rising in 2001 and many remained convinced for some time that the rally wouldn't last. So don't expect any significant increase in mining output until well after 2010. Barrick Gold closing out its large hedge book though is an indication that they believe gold output is likely to continue falling and prices to continue rising.

While high gold prices mean that jewelery demand will fall, the rise in investment demand will more than overwhelm any drop. In a number of developing economies, jewelery and investment demand are not actually distinguishable as is. Purchasing high-caret jewelery is the traditional method of investing in gold. While India has been the number one market for gold demand, China seems to be in the process of overtaking it. There were significant restrictions that limited gold buying by the Chinese until the early 2000s. Gold demand there has been soaring since the restrictions were lifted.

There are a number of major long-term trend changes going on in the gold market and none of them are likely to end soon. There is probably at least another decade before a new equilibrium is established and major shifts start occurring again and drive the price of gold back down. By the time that happens though, the price of gold is going to be much, much higher than it is today.

Disclosure: Long gold and silver.

NEXT: Is the Gold Rally Getting Frothy?

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21


This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Real Story About Gold Supply and Demand

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Our Video Related to this Blog:

Just once I would like to see a media article that had a accurate supply and demand analysis for a commodity. Usually reporting is completely one-sided with only supply or demand discussed out of context. No matter how much detail is provided for one, it is meaningless unless you have information on the other. Media coverage of oil is notorious for providing this incomplete picture. The gold market is apparently not immune to it either.

Media reports today include "Gold Demand Falls 34% in 3rd Quarter: World Gold Council". A dire picture of falling demand for gold is painted. Supply issues are at least lightly, albeit very incompletely broached. While you are left with the impression that this news should be devastating for gold prices, if you check you will see that gold had a nice rally between July and September. Anyone who took the first week of economics 101, would immediately conclude the supply versus demand picture must have improved. Reporters are most likely to have been journalism or English majors and may not have even the rudimentary knowledge needed to be aware of this. They frequently miss the real story for the same reason.

Much is made in the gold supply figures about a drop in Indian demand, down 42% to 111.6 metric tons year over year in the third quarter. Not mentioned was that there are times that are considered inauspicious for buying gold in India and that period was twice as long in Q3 2009 as it was in Q3 2008. India consumer demand for gold is followed closely because it has been the number one source of demand for gold from seemingly time immemorial. However, World Gold Council figures indicate that the Chinese bought 128.6 metric tons of gold in the third quarter of this year outpacing the Indians. A little research also reveals that the Chinese bought more gold in the first half of the 2009 than the Indians as well. Retail price controls were only abolished in China in 2001 and since then consumer gold purchases have consistently outpaced GDP growth. China is clearly becoming the top market for gold knocking India off its perch. This is a big story. While that's the the headline you should be seeing, that's not what is being reported.

The World Gold Council also claims that investment in gold coins and bars were down 31% year over year and gold ETF inflows were down 72% year over year in the third quarter. If this is true, something has to be taking up the slack, either more demand elsewhere or decreasing supply. This is some vague reference in their press release about financial instruments and dehedging somehow creating more demand for gold. The specifics are not stated though. Hedging by mining companies is indeed dropping rapidly falling from 530 metric tons in Q3 2008 to 359 metric tons in the third quarter of this year. Barrick Gold (ABX) has been closing out its large hedge book and this has been helping to push gold prices up lately. Closing out hedges has the same effect for commodities as short covering does for stocks.

Miner hedges are only the tip of the iceberg however when it comes to short covering in the gold market. Mining hedges represent only around 20% of central bank leasing for gold. Central banks have been lending out their gold for years to miners, big banks and hedge funds (this is how they make money on their holdings). This usually results in an immediate sale of gold on the market and this was a major factor in keeping gold prices down in the 1980s and 1990s. Leasing has been in rapid decline during the 2000s however and you may have noticed the price of gold has gone up as leasing has diminished. It is estimated that there were 4300 metric tons of gold leased by central banks in 2004 and this was down to 2345 tons by the end of 2008.

The World Gold Council admits gold supply fell 5% in the 3rd quarter. There have been 3 main sources of market supply for gold in the last two decades - mining, scrap and central bank selling. So far gold mine production peaked in 2001 and then dropped year after year. It looks like it will be up this year. Supply from scrap is highly variable. Sales were 569 metric tons in the first quarter of this year, but were down to 283 tons in the third quarter. Central bank selling seems to have turned into net buying. Central banks accounted for 14% of gold market supply just a few years ago. This fell to 8% in 2008. Central banks bought a net 15 metric tons of gold in the third quarter of 2009 (this doesn't have anything to do with the Indian central bank purchase of 200 tons of gold recently, that took place in the 4th quarter). Central banks shifting from being a source of supply to a source of demand represents a major sea change for the economics of the gold market - something else that is worthy of headline coverage.

Spot gold has reached as high as $1153.90 recently and has been hitting one all time high after another in the 4th quarter so far. The market tells you what the actual supply demand picture is quite clearly. If it contradicts the information you are receiving, it is because that information is incomplete or wrong. Believing otherwise is a sure way to lose money.

Disclosure: Long gold, no positions in ABX.

NEXT: U.S. Interest Rates Go Negative Again

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21


This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.